To many if not most investors, insider trading and stock manipulation self-evidently need to be outlawed if the equity market is to deliver both fairness and an optimal allocation of capital. The authors of The New Stock Market, however, do not take that conclusion for granted. They insist that advocates of prohibition or regulation run the gauntlet of documenting these practices’ impact on wealth distribution, price accuracy, and market liquidity. Furthermore, the book contends, those who favor restriction must determine whether the activity has a positive expected profit. If it does, they say, that is an argument for criminalizing it.
Welcome to the equity market as seen by law professors Merritt B. Fox (Columbia University) and Gabriel V. Rauterberg (University of Michigan), in collaboration with finance professor Lawrence R. Glosten, who co-directs Columbia Law School’s Program in the Law and Economics of Capital Markets. Viewed through these academics’ lens, informed trading, the function supported by CFA charterholders engaged in fundamental analysis, disadvantages ordinary investors by reducing secondary market liquidity. High-frequency trading tactics that author Michael Lewis derides as “electronic front-running,” however, benefit ordinary investors by narrowing bid–ask spreads and thereby increasing liquidity.
Investment professionals with a conventional understanding of markets will expand their horizons by studying the authors’ perspective. For example:
For reasonably thickly traded stocks, the efficient market hypothesis assures that prices fully reflect all publicly available information. This assumes that the reported prices are the result of trades genuinely involving value calculations on the part of all buyers and sellers (other than the uninformed, who have no influence on price). Wash or matched sales cause the price to deviate from this efficient price and hence make it a less accurate appraisal of an issuer’s future cash flows.
Some of the discussion is fairly abstract, as it methodically runs through the logically assumed effects of various market features (e.g., short-selling, dark pools, and payment for order flow). The reader periodically encounters such statements as “Existing empirical research is not very enlightening,” “The conclusions of empirical literature . . . are mixed,” “No consensus exists among financial economists,” “Rigorous work on this issue is lacking,” and “To reach a definitive answer, . . . we would need to know more than we currently do.”
The authors are candid about these limitations in formulating their policy proposals. Also, while characterizing certain public perceptions of unfairness as misunderstandings, they acknowledge that those perceptions may have detrimental effects that warrant regulatory remedies. Where they believe intervention is needed, they decline to be constrained by the absence of perfect knowledge.
Among their prescriptions is a requirement that maker/taker rebates and payments for order flow be passed on to customers. Additionally, Fox, Glosten, and Rauterberg criticize the US Supreme Court for having rejected a writ of certiorari asking it to resolve the question of what constitutes market manipulation, a matter on which the circuit courts have split. They urge the high court to resolve the issue in favor of the Second and D.C. Circuits’ position, which rejects the notion that trading behavior alone cannot constitute a manipulation but must be accompanied by some other unlawful act.
Veteran practitioners who are unaware of the risks posed to traders by the lack of a clear definition of manipulation will probably also be surprised to learn of an entire category of manipulation involving floating-price convertibles that heretofore may have escaped their notice. In addition, they may do a double-take at the authors’ proposal to replace US Securities and Exchange Commission Regulation FD, which prohibits selective disclosure, with a rule permitting companies to pay analysts to follow them. After all, credit rating agencies have had to devote considerable energy to refuting the frequent presumption that their objectivity is compromised by having an issuer-funded business model.
On a related point, a coda on application of the authors’ information-based approach to the corporate bond market slightly undercuts the book’s otherwise high marks for thoroughness. The authors seem to believe that prices of highly distressed issues alone are sensitive to issuer-related information. That notion is belied by the very considerable resources devoted to fundamental analysis of non-distressed, speculative-grade — and even investment-grade — corporate bonds by money managers, investment banks, and independent research organizations.
Notwithstanding that underdeveloped digression into possible topics for future research, The New Stock Market is a truly impressive achievement. It deserves an audience not only among scholars to whom its intellectual framework is already familiar but also among practitioners. Analysts, portfolio managers, risk managers, and C-suite executives who read this book will afterward stand on much firmer ground when opining on prospective securities legislation and regulation.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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